Yield Curve Is a Graphical Thesis

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Another influencer of the curve is the markets for different Fed maturities. This variable can distort the yield curve, hindering its ability to act as an economic predictor. Another potential constraint on the outwards bounds of the yield curve as a predictor is that the ten-year bond is the longest one with a consistent, liquid market.

The Fed and the broader market typically use the yield curve as a predictor of recession going out a year, maybe a year and a half. Going further is a more esoteric matter. Plosser and Rouwenhorst (1994) showed that "term structure has significant predictive power for long-term economic growth" in part because it contains information about future real activity that is "independent from information about current of future monetary policy." They argued that the spread could predict accurately up to five years forward, but with the caveat that this predictability was heavily influenced by the spread's ability to predict just two years forward (Dotsey, 1998). Subsequent research on the predicative power of the yield curve focuses on the shortcomings of the model, and on shorter-term predictions, between six months and a year. Further research attempts to deconstruct the predictive power of the yield curve.

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What we are left with, then, is the supposition that economic activity can be predicted up to five years into the future with the yield curve. This supposition, however, is weakly supported. Plosser and Rouwenhorst's support of two-year predictability is much stronger. Settling on two years as the outer limit of predictability is reasonable given the lack of evidence to support a further time frame. To achieve such predictability, it may be better to use a spread based on the ten-year and a one year bond, rather than the Fed funds rate or a 3-month T-Bill.

This area has strong potential for future research. When research yields better information about the reasons why the yield curve is a predicator for economic activity in the short-term, then that will provide a framework for analyzing the usefulness of the curve beyond two years.

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